It seems that market timing is one of the easiest things for financial journalists to pick on.

“Market Timing is Bunk,” reads the headline of a weekly email newsletter written earlier this year by Pat Dorsey of Morningstar Inc.

Dorsey wrote: “Folks, this is one of the all-time great myths of investing. There is no strategy that consistently tells you when to be in the market and when to be out of it. None. Anyone who tells you otherwise has something to sell you – usually a market-timing service.”

The rest of this article is an open letter to Mr. Dorsey, who obviously doesn’t know or doesn’t understand the facts about market timing. I’ll make sure he gets a copy of this newsletter, and if he cares to respond, I’ll give that response a fair airing right here.

First, Pat, every timing strategy I know of does consistently tell investors when to be in the market and when to be out. We have done it consistently, with never a gap, for many years. I think what you meant to say is that no market timing system does a perfect job of telling investors the very best times to be in and out of the market. And of course that’s accurate.

However, somebody could criticize Morningstar’s stock analysis by pointing out that your company’s buy and sell recommendations don’t always make money for investors who follow them. Of course they don’t! Who would expect such perfection?

Market timers don’t expect perfection from their systems either.

In your column, you quoted Jack Bogle of Vanguard as saying: “After nearly 50 years in this business I do not know of anybody who has done it successfully and consistently.”

Here’s a question for you: What would it take, in your view, for a market-timing system to be consistent? What would it take for a timing system to be successful? Neither you nor Bogle say, and therefore your readers don’t have any way to evaluate the merits of your assertions. And I have no way to try to refute them.

You also wrote: “Moreover, when’s the last time you heard someone advocating market timing who wasn’t trying to sell you a proprietary system or service to get you out at the top and in at the bottom?”

Many thousands of people have heard me advocate market timing on the radio, in our free workshops and in my articles on market timing. Not one of those people has ever heard me say or imply that timing can get investors in at the bottom and out at the top. The way we do timing, that won’t happen. More important, it doesn’t need to happen.

You wrote: “Another question: If the systems being touted are so darn good, why are the creators wasting their time trying to get a few hundred bucks in subscriptions … rather than leveraging themselves to the hilt based on their own signals?”

In fact, we use 50 percent leverage for some of our own accounts and some clients’ accounts, using our market timing signals. And I hope you’ll keep reading, because we’ll show you the results that we have actually achieved managing money for clients.

When I read your warning to readers that “By trying to time the market, you are essentially gambling with your financial future at very poor odds,” I must admit that I thought to myself: I could say exactly the same thing about investing in individual stocks, which is what you encourage in your job as director of stock analysis at Morningstar.

But let’s get to the facts about timing, because they are very interesting and I would like you to understand them.

Many people believe that in order for timing to work, a system must get investors in at the bottom and out at the top. Obviously that’s impossible except by pure luck. But if you can get into the market in the early stages of a rally and get out in the early stages of a downturn, you can make money and preserve your gains.

Our timing systems don’t rely on forecasts. Instead they identify existing price-based market trends that – based on history – are likely to persist long enough for investors to take advantage of them.

Ideally, a timing system allows investors to capture most of the gains in a bull market and avoid most of the losses in a bear market. It is never that neat and simple in practice, of course, and the short-term investments that result from timing signals often turn out to be counterproductive.

But when it is given enough time and done properly, timing definitely works. I want to be sure you know exactly what I mean when I say that. I don’t expect timing to “be right” even half the time. In practice, the majority of trades generated by timing systems result in losses.

My standard for a timing system to “work” is met if the system reduces the risks of being in the market and still captures most of – ideally more than – the return of holding the same assets over the same period on a buy-and-hold basis.

Timing always reduces risk by getting investors out of the market part of the time. Every day that your assets are in a money-market fund is a day the stock or bond market is not going to take those assets away.

Generating decent returns is, of course, the challenging part of timing. In the short term, the returns from market timing are more often frustrating than rewarding. But over longer periods, the results get better.

I’d like to call your attention to the figures in Table 1. These show actual real-time results from accounts that we manage for clients.

The column labeled “U.S. Equity w/ timing” represents results each year (and the first six months of this year) for clients in one of our core timing strategies.

The column labeled “U.S. Equity w/ timing & leverage” represents work we do for other clients who, as your column suggested, wish to take the additional risk of using borrowed money when our timing systems indicate the chances of gains are the strongest.

All these figures are after all trading costs, interest costs and our management fees.

The column labeled “U.S. Equity funds average” represents the average results, without any timing, of all U.S. equity funds followed by Morningstar.

At the bottom of each column is a line labeled “Total return,” showing the bottom line for this 7 ½ year period.

As you can see from the bottom line, market timing without leverage fell behind the average of all U.S. equity funds for the whole period. But the very combination of timing and leverage that you suggested in your column outperformed the unmanaged all-funds average.

If you compare returns for individual years, you’ll see that the results vary a lot. Each approach had its comparative successes and comparative failures. This means you and John Bogle are correct that timing is not consistent. Neither is timing with leverage. And neither is buy-and-hold investing.

We also use timing with bond funds, and we’ve been more consistently successful in that endeavor. The following table compares actual results, again after costs and fees, of our client accounts in U.S. high-yield bond funds with Morningstar’s average of all U.S. high-yield bond funds.

Here again, there is no consistency. In the first three years of this period, timing produced very similar results to the high-yield fund average. But in 1998, timing turned a losing asset (all high-yield funds) into a winning one. And in 2000, timing slashed the losses that buy-and-hold investors experienced.

Here’s another interesting observation from the table: In each of three calendar years (1996, 1997 and 2001) our timing strategy underperformed – by an average of 1.1 percentage points for each period. By contrast, in 1998, 1999 and 2000, timing outperformed – by an average of 5.5 percentage points. This illustrates a pattern we’ve seen again and again: A good timing system tends to generate small losses and larger gains.

When you consider that timing indisputably reduced the risk of investing in bonds, I believe this is solid evidence that timing did in fact work.

Of course this doesn’t say anything about the future. As you know very well, past results do not indicate future results. Probably the only thing we can say for certain is that future results will be different from those of the past.

If you have read this far, Pat, I hope you have learned enough to want to at least take a second look at market timing. Ideally, you’ll be a little less quick to condemn it out of hand.

Along with the copy of this newsletter that I’m mailing to you I’m enclosing printed copies of three articles from our Web site: “Which is Better, Buy-and-Hold or Market Timing?” “The Best Retirement Portfolio We Know Using Market Timing” and “Do You Have What it Takes to be a Successful Market Timer?” I hope you’ll read these articles and let me know what you think.

You’ll see that we recommend investors use multiple timing systems and use only mechanical systems. You’ll see we advocate proper asset allocation as more important than timing – because even if your timing is perfect, if you are timing the wrong asset, it won’t take you where you want to go.

And you’ll see that we think most investors who use timing should also use a buy-and-hold approach for some of their assets. That’s a smart piece of diversification, especially because there are many years when timing and buy-and-hold perform quite differently.

We have more than 800 clients who have avoided big losses these last few years because we were using market timing on their behalf. And this isn’t just a recent phenomenon. Many of our clients benefited in 1987, when our timing systems got us completely out of the market a month before the big crash, a crash that nobody had predicted by then. I hope you’ll remember this next time you are tempted to condemn timing and timers.

Finally, Pat, I invite you to respond to this article. As I said, I promise to give your comments a fair audience in this newsletter.

 

 

 

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